The coming sharemarket rally

If you’ve read anything from The Motley Fool, you’ll know we’re neither market timers, nor are we technical analysts. Personally, the only ‘double top’ I know is the soft-serve variety. There’s a very real difference between trying to pick the bottom and knowing when shares are undervalued. Looking at the ASX today, I have no idea – at all – whether we’ve seen the bottom. I simply have no way to forecast irrationality. What I do know is that shares are cheap compared to historical norms and that pessimism and uncertainty reign. It might be uncomfortable, but that’s exactly…

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If you’ve read anything from The Motley Fool, you’ll know we’re neither market timers, nor are we technical analysts. Personally, the only ‘double top’ I know is the soft-serve variety.

There’s a very real difference between trying to pick the bottom and knowing when shares are undervalued. Looking at the ASX today, I have no idea – at all – whether we’ve seen the bottom. I simply have no way to forecast irrationality.

What I do know is that shares are cheap compared to historical norms and that pessimism and uncertainty reign. It might be uncomfortable, but that’s exactly the time to buy. When optimism returns, the opportunity will have passed.

Perpetual gloom
There’s plenty of bad news in the market today. Bad news gets the headlines, and once the market gets on a roll, the news becomes self-fulfilling. The net result of a few years of continued pessimism is a market that doesn’t fully appreciate – or value – the earnings power of the companies on the ASX.

Not every company is cheap – there are plenty of resources companies praying that mineral prices stay at record highs – but there are enough of them to make the ASX a fertile hunting ground for investors.

The Australian All Ordinaries index has averaged between 15 and 16 times earnings over the past 25 years. It’s currently sitting around 11. At the same time, dividend yields are well over the long run average.

The implication of these statistics is that investors, as a whole, believe the future will be much tougher than the past. In an environment of depressed consumer confidence, the market is betting that demand will be soft for a long time to come which will keep corporate profits low.

The future will be better than the past
Here’s where I differ from the crowd, and why I think now is a great time to buy. Companies that have survived the creative destruction of capitalism over the past few years have emerged in stronger shape. Consumers have already tightened their belts, and spending will pick up. The future is very likely to look better than today’s market is predicting (because of its over-reliance on events of the recent past).

If you accept that assumption (and it’s been true since the dawn of time, not withstanding occasional periods of over-reaching and pull-backs), then what becomes clear is that many of today’s prices are cheap.

We know that when corporate profits improve, share prices move with them. When companies are fairly valued, the improvement in share prices will move in tandem with the underlying profits.

Benefit twice from profit growth
But if, like today, many shares are undervalued, any profit improvement will have two compounding impacts.

Firstly, the move in profits will lift share prices, as I mentioned above. So far, so good. The extra benefit for investors who buy today is that sustainable, growing profits will have the effect of reversing the market pessimism, and price/earnings ratios will return to more normal levels.

That so-called ‘multiple expansion’ is the upside for investors who ignore the crowd and look through the pessimism – the reward that comes from thinking for yourself.

The timing of the rally might be uncertain but if you wait for the market to recognise its own moodiness, the opportunity will pass you by. Yes, you might have to wait a while for the gains to come, but if you’ve invested well, they will come.

Downside protection
If you’re particularly eager to protect your downside, there are a couple of things you can do to reinforce your portfolio.

First, only buy shares that have a large margin of safety – the companies which are most undervalued.

Secondly, you might want to consider quality companies that are offering high dividend yields. There are plenty of those around at the moment, and they’ll effectively pay you to wait for the market to recognise its mistake.

Foolish take-away
There are quite a few businesses trading on the ASX at very reasonable prices. Investors who buy shares in these businesses at current prices are likely to do very well in the years to come, even if price/earnings ratios never improve – the current price and future earnings potential will be enough.

History tells us that price/earnings multiples usually return to their averages (and higher) throughout the market cycles. If the market returns to its average, the return from margin expansion alone could be 30% or more – on top of the price increases that will come from the growth in profit.

That’s on average. Choose well, and you could do even better. Picking tops and bottoms is for mugs. Instead, just focus on buying when shares are cheap, relative to the likely future earnings.

In time, the market should do the rest.

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This article authorised by Bruce Jackson.

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